“Blue Chip Forced by Law to Embarrass Itself”

by Travis Johnson, Stock Gumshoe | June 1, 2008 12:01 pm

This teaser starts out with a promising … um, promise:

“We just uncovered one of the largest opportunities we’ve ever seen. One of the fat cat financial firms on Wall Street just received some bad news. By June 17, it could be forced by law to reveal some really embarrassing data. That’s not what’s so exciting…

“It’s the fact that we have a hidden way for you to possibly make up to three times your money by year-end. To get in on this opportunity, you have to read the report below…”

How could you not read on after that? There’s a reason these copywriters get paid well. The ad is for Dan Amoss[1]’ Strategic Short Report[2], which we’ve looked at before, back in January when they first started teasing us with their “paddle strategy[3]” for profiting in down markets.

And during times like these the ads look extraordinarily compelling — when we’re all in fear that even the blue chip financial firms will collapse, and that we’re all sitting in a rickety handbasket, moving fast, with some qualms about exactly where we’re heading. During times like these, the idea of piling on to bet against these collapsing stocks seems like a no-brainer.

The special report you receive when you subscribe is called, “Wall Street’s ‘Secret Shame’: How to Make Money-Tripling Gains on the Next Wave of Wipeouts and Write-downs Ahead.”

Of course, piling on to a short trade that has a lot of people in it already can be just as bad as chasing a momentum stock — they can move against you almost as quickly, sometimes more so. But the greed impulse that makes us feel like we’re missing out on a hugely profitable investment is compelling in either direction. Amoss, by the way, would like $995 for his special report, and for your subscription to his newsletter.

In that report, above all else he implies that he will reveal to you the best short idea he has now — and there’s an urgency to it, because apparently you have to get in before June 17 at midnight if you’re going to make this play.

The big argument he makes is essentially that there are two more potential financial catastrophes ahead, the resetting of the Option ARMs and the Alt-A mortgages (as opposd to the subprime mortgages, which have already collapsed). He shows a frightening chart that shows 2009-2011 looking like the massive mountains of those mortgages are going to collapse and bring down Western Civilization with it.

Then, a bit further down, he shows lots of happy charts — charts that show the gains, mostly in the several hundred percent range, that you could have gotten by betting against some of the well-known blowups of the last year or two — Etrade, Circuit City, Nutrisystem, and Citigroup.

The charts raise some questions for me, since the “paddle strategy” seems still to be focused on using options[4] to bet against stocks (buying put options would be the safest and easiest way to do this, generally). But the commentary in the ad says that Amoss wrote to his subscribers about Nutrisystem being an accident waiting to happen in May of 2006. The accompanying chart indicates that the “market woke up to” Dan’s concerns about the company a year and a half later, in September of 2007, creating the perfect opportunity to bet against the shares.

The concern I have is that with options — and to a lesser degree, since there are always carrying costs, with any short bet — timing is everything. If you had bet against Nutrisystem in May of 2006 you would have been wrong for the next year as it bounced around near all-time-high prices. If that bet had taken the form of many of the put options on those shares, there’s a good chance you would have lost much or all of your investment waiting for the short thesis to play out. Amoss was right in the end — Nutrisystem did fall like a load of bricks — but it’s often not enough to be right about the direction if you’re using options in either direction (and, to a lesser degree, shorts), you have to also be right about the timing.

So I’ll accept that Amoss seems to have shown some success in betting against the market, and he’s fairly well known for this — but would just caution that it’s very hard to get the timing of these calls right, even if you get the direction. Don’t assume that someone who can predict the direction will necessarily be able to consistently tell you exactly what options expiration date you need to choose to buy put options that will make you money.

But enough of my chatter … let’s see which company Amoss thinks is headed for a fall, starting June 17 and over the next six-eight months.

He says that it’s a blue chip Wall Street firm, and that it’s reporting earnings right around that date. That narrows it down to three … and really, just to two since one of them reports on the 17th, before his “deadline” hits.

Those two are Lehman Brothers[5] and Morgan Stanley, both of which will probably report earnings on the 18th or 19th … the one that has announced it will be reporting on the 17th is Goldman Sachs, which many people are whispering might have hidden skeletons, but which most people seem to be afraid to bet against due to their golden image and their ridiculously prescient bet against subprime in their own accounts last summer (at a time, of course, when they were reportedly happily packaging and selling those mortgage bonds to others). There’s nothing stopping Lehman from reporting on the 17th, as far as I know, they did report on the same day as GS last quarter, this is just guessing at dates since I don’t think they’ve announced an earnings release date and they always report at roughly the same time as Goldman, since all three of them end their fiscal quarter today. Merrill Lynch[6] and the big banks, JP Morgan and Citigroup, et al, are mostly on the calendar quarter, so we won’t hear from them for another month after that.

So … Lehman or Morgan? Both have been train wrecks already, both are insanely cheap on an estimate of forward earnings (for very good reason), both have exposure to all kinds of toxic subprime, CDO, auction rate, and other similar assets that continue to cast a pallor across fixed income trading rooms worldwide.

Lehman, however, is the natural bet — they’ve traditionally been bond specialists, and when Bear Stearns was going down and in the weeks to follow, it was extremely popular to predict that Lehman was next on the chopping block. They did some good damage control, appearing everywhere to assuage investor fears, and raising new capital … but no one quite trusts them just yet.

The clues to back that up?

This is what we’re told about this company:

“At least 1 anonymous derivatives[7] dealer has already started to cut his ties to this firm. So have some big Asian banks

“Over 100 of this firm’s mortgage-backed investments have already been downgraded or marked for a possible downgrade by Moody’s, the ratings agency

“This one firm already has debt-to-equity leverage[8] of about 32-to-1. That means it’s borrowed — and owes — $31 on every $1 of assets it owns. It also means the value of this firm’s investments can’t fall more than 3% right now before it’s completely wiped out

“And by the way, this one firm has nearly $90 billion in potentially dangerous debt-backed assets. And nobody on Wall Street is interested in buying

“Bondholders have already started dumping this firm’s bonds, too

“And now, top analysts on Wall Street are already whispering behind closed doors about the possible “fuzzy math” and accounting tricks that may have been used to fudge this firm’s bottom line over every financial quarter of the last year”

So … to confirm at least one of those details, DBS, the big Singapore[9] bank, did get quite a bit of attention when they changed policy and decided not to do business with Lehman back in March. And Lehman’s derivatives trading business was not that big anyway, compared to Morgan Stanley or Goldman, who are both still highly rated in that area, so it wouldn’t be surprising if they lost a customer or counter party or two in that area.

I don’t know that the debt/equity leverage of 32 matches exactly, since there’s more than one way to represent that number, but Lehman is at least as highly leveraged as the other investment banks — and they’re pretty much all leveraged up the wazoo. Lehman’s enterprise value, which is market cap plus net debt, is negative $200 billion on a market cap of just $20 billion. To be fair, enterprise value is not a particularly flattering number for any investment bank, they all look comparably bad on the surface because the only way their business can be highly profitable is if they use buckets and buckets of leverage.

Not that very many people are jumping up and down for the opportunity to buy Morgan Stanley shares at the moment, either, of course, but I think Lehman is the “paddle strategy” stock Amoss is talking about here.

And the “fuzzy math” bit is decidedly not just “behind closed doors” — there has been pretty good coverage recently in the financial press about the fact that many of these firms have seen a fair part of their earnings recently come out of a ridiculous change to accounting rules. In this case, mark to market accounting means that these firms can record earnings when their outstanding debt declines in value. That’s absurd, of course, since regardless of the market value of their bonds they have to pay back the full par value to bondholders at the end of the term, and they don’t lose that obligation just because people are only willing to pay 70 cents on the dollar for their bonds today.

The “embarrass itself” part is no particularly big deal — financial firms are forced to value their assets and their debt each quarter, so the theory that they’ll embarrass themselves is based on a forced revaluation of either their own debt or their assets. Most people are speculating, and there was a good update on this in Barron’s over the weekend — an update that also went inot some detail on that same accounting earnings “fuzzy math” (here’s the link if you happen to subscribe[10]), that these shares still look troubled — not least because they’re in the sights of David Einhorn[11], a famous short investor who runs Greenlight Capital.

Lehman has already fallen more than most of the others in recent weeks, FYI, and their shares already trade for less than their book value, so if you do decide that you think it’s worth betting against them you will be participating in what most people persist in calling a “crowded trade” — meaning there are lots of other people making the same bet as you, so you’re going to have to be right or the crowds will leave in a hurry, bringing a world of hurt. Clearly, betting against them three months ago would have been a brilliant move … and even three weeks ago would have given you a nice profit, so you’re already looking at damaged goods.

“Crowded” means popular, too, so that means you’re certainly not being contrarian … which means a lot of other people have been trying to buy these puts, which means that they will cost more than they otherwise would (Lehman puts will cost you a significantly higher premium than buying Goldman Sachs puts for the same time frame and percentage move, for example).

Lehman puts for January 2009 that are roughly at the money (near the current share price — in this case $36 puts, which give you the right to sell the shares anytime before the third Friday in January for $36), will cost you a 20% premium — about $6, meaning that the shares would have to fall to $30 on or before the expiration date for you to be able to exercise those options and make money doing so. Of course, most options traders never exercise the options — so the option price might go up or down and that implied premium might change before then even if the shares never move, so you could make a profit on the options even if the shares don’t go down from here, if people start to fear that they’ll go down. But it’s certainly not guaranteed.

And if Lehman goes bankrupt, you make a massive profit — you could, in effect, possibly buy the shares of the bankrupt company for pennies and sell them for $36. Of course, the implication of the markets is that someone would rescue a big house like Lehman before it got that bad, so it probably wouldn’t go to zero or anywhere near it, but I suppose anything is possible.

I don’t generally go short the market or bet against individual stocks, I typically only use put options to hedge large positions that I’m a little concerned about, so this isn’t something I’m going to try to make money from. And in all honesty, most of the investment banks just confuse the bejeezus out of me — I have no idea what their worth, and I’d be afraid that it could be markedly less or markedly more than I’d guess, so there’s no advantage in guessing. I’ll leave that to Dan Amoss and the professionals … but if you’ve got a reason why we should bet either way on these guys, by all means, let us know.

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